Asaf Eckstein is Associate Professor of Law at Ono Academic College and Gideon Parchomovsky is Robert G. Fuller, Jr. Professor of Law at University of Pennsylvania Law School and Professor of Law at Hebrew University School of Law. This post is based on their recent paper.

The agency problem, the idea that corporate directors and officers are motivated to prioritize their self-interest over the interest of their corporation, has had long-lasting impact on corporate law theory and practice. In recent years, however, as federal agencies have stepped up enforcement efforts against corporations, a new problem that is the mirror image of the agency problem has surfaced—the reverse agency problem.

The surge in criminal investigations against corporations, combined with the rising popularity of settlement mechanisms including Pretrial Diversion Agreements (PDAs), and corporate plea agreements, has led corporations to sacrifice directors and officers in order to reach settlements with law enforcement authorities, at all cost. While such settlements are in the best interest of companies and shareholders, they have devastating effects for individual directors and officers.

To begin with, because enforcement authorities condition entering into a settlement on full cooperation on the part of the corporations, and give corporations credit for cooperating with the investigating authorities, which comes in the form of a reduced fine, corporations have a strong incentive to cooperate fully with the investigation led by the enforcement authorities, mainly the DOJ or SEC. This includes also providing the authorities with a full access to privileged materials, even those that come under the attorney-client privilege, and align corporations’ interests with those of the authorities. The famous case of KPMG is illustrative. In 2003, the DOJ launched a criminal investigation against KPMG and many of its employees concerning the designing, marketing and implementing of illegal tax shelters. The DOJ took full advantage of KPMG’s vulnerability, pitting the company against its own employees, as described at length in the decision of Judge Lewis A. Kaplan of the Federal District Court in Manhattan:

“The government took full advantage. It sought interviews with many KPMG employees and encouraged KPMG to press the employees to cooperate. Indeed, it urged KPMG to tell employees to disclose any personal criminal wrongdoing. When individuals balked, the prosecutors told KPMG. In each case, KPMG reiterated its threat to cut off payment of legal fees unless the government were satisfied with the individual’s cooperation. In some cases, it told the employees to cooperate with prosecutors or be fired. The government obtained statements, commonly known as proffers, from nine KPMG employees who now are defendants here (the ‘Moving Defendants’). . . Having considered the evidence, the Court is persuaded that the government is responsible for the pressure that KPMG put on its employees. It threatened KPMG with the corporate equivalent of capital punishment. KPMG took the only course open to it.”

Judge Kaplan proceeded to state that the use of the Thompson Memo by prosecutors has produced “the exertion of enormous economic power by the employer upon its employees to sacrifice their constitutional rights.” This concern of violation of employees’ Fifth Amendments rights in the context of criminal investigation within the firm has attracted also the attention of Eastern District of New York Judge John Gleeson in the oft-cited case of HSBC. The American Bar Association, the U.S. Chamber of Commerce, and the National Association of Manufacturers, also voiced serious concerns about the “culture of waiver” adopted by the DOJ.

Relatedly, as a part of the agreements, the corporations are required to admit to various counts of wrongdoing by their directors, managers, and other employees. These agents, many of whom are no longer employed by the relevant companies at the time the agreement is consummated, typically have little or no say in the process and will forever have to live with the admissions that their corporations have made—admissions that implicate them in wrongdoing. And although these admissions, described by Richard Epstein as “confessions of a Stalinist purge trial,” do not formally bind directors and officers, they have a profound impact on their future. These directors and officers suffer severe reputational losses as a consequence of these agreements, which often translate to lost careers and lost income.

Worse yet, the admissions made by corporations invariably expose directors and officers to follow-up civil suits against them. The admissions in settlement agreements speak of various failures by the directors and officers. They are drafted in strong language and, thus, serve as an invitation to shareholders to demand that the corporation sues its directors and officers for a breach of the duty of loyalty or a breach of the duty of care, and if the corporation refuses to do so, to initiate a derivative action against them.

Unfortunately, extant law does not provide directors and officers with a means to prove their innocence or clear their name. In fact, it does not even give them a voice in the negotiations leading to the drafting of settlements. Thus, it dooms many directors and officers who have done no wrong to live with the mark of Cain and endure the economic consequences thereof. To remedy the plight of individual directors and officers, we suggest three possible legal reforms. The first mechanism seeks to amplify the voice of individual corporate officers in settlement negotiations by giving them a right to a hearing prior to the finalization of a settlement. This mechanism would enable individual directors and officers to review settlements and propose changes before they are signed. The second mechanism we contemplate is to give individual directors and officers who were implicated in settlements the right to bring an action for a declaratory judgment that could clear them of liability. Doing so will grant innocent directors and officers the power to initiate legal actions in order to dispel the suspicions surrounding them and preempt derivative actions against them. Our third, and the most far-reaching mechanism, is to allow innocent directors and officers the right to sue their colleagues who went astray and precipitated a cascade of harms on the corporation and its employees.